Flows into credit mutual funds are surging in India, providing a welcome fillip to lower-rated borrowers while exposing investors to higher risks at a time of rising bad debts. Assets under management at credit opportunities funds, which invest mostly in bonds with domestic ratings below Triple A, rose 65 percent to 1.09 trillion rupees ($17.1 billion) in the year to the end of April, according to data from Crisil. They increased further to a record 1.14 trillion rupees in May.
"In the current scenario of low interest rates, the rise in appetite for credit opportunities funds can be attributed to the search for higher yields," said Jiju Vidyadharan, director of funds and fixed income research at Crisil. Bonds that Crisil rates A currently yield 180 basis points more than AAA rated instruments. "A structural decline in term structure of interest rates in other asset classes such as bank fixed deposits, government bonds and tax-free bonds may have also contributed to an increase in the risk appetite," said Dhawal Dalal, chief investment officer for fixed income at Edelweiss Asset Management.
At the end of May, credit opportunities funds had allocated 47 percent of their portfolios to paper rated AA, 25 percent to A and below, 21 percent to AAA/A1+ and the rest to cash or unrated bonds, according to Value Research. The growth in credit funds has helped lower-rated companies tap the debt market at a time when banks, saddled with stressed assets, are cautious to lend. "Of late, debt capital markets have been taking up the space vacated by banks in terms of lending, especially in cases of highly rated transactions both in the plain vanilla and structured space," said Amit Tripathi, chief investment officer for fixed income at Reliance Mutual Fund.
Debt private placements of AA rated issuers nearly tripled to 867 billion rupees and those of A+ rated issuers nearly doubled to 248 billion rupees in the year to March from a year earlier, according to Prime Database. Investors have put so much money into credit funds that they could be hit hard in the event of sharp rating downgrades, analysts and regulators worry.
On Thursday, Securities and Exchange Board of India chairman Ajay Tyagi cautioned that Indian mutual funds needed to improve their due diligence before investing in corporate bonds and not rely exclusively on credit ratings. "Care should be taken that non-performing loans do not get shifted to mutual fund portfolios by way of transfer of debt," he said. There are plenty of recent examples of investors losing money because of credit risks.
In May, a downgrade of IDBI Bank's debt instruments impacted the funds holdings its bonds. In February, Taurus Mutual Funds debt portfolios fell sharply after Ballarpur Industries was downgraded.
Last year, Franklin Templeton Asset Management sold its entire holdings of Jindal Steel and Power at a loss following ratings downgrades. In 2015, a J.P Morgan mutual fund suffered losses because of its holdings in Amtek Auto debt. The car components maker was finally forced into insolvency proceedings by the Reserve Bank of India two weeks ago.
Some fund managers acknowledge the need for caution. "While markets in India provide adequate tools as well as underlying liquidity to manage duration risk, they don't as yet on credit risk," said Suyash Choudhary, head of fixed income at IDFC Asset Management. Credit opportunities funds have grown very strongly over the past couple of years, presumably because investors were attracted by the relative stability of their returns compared to duration-oriented funds, Choudhary said.
"However, unless this is backed by a reasonable understanding of how credit risk works, and consequent deviation in returns that can occur versus expectations down the line, there is a risk that some investors may be over-allocating," he said. Reliance Mutual Fund's Tripathi argues that diversification can mitigate some of the risks, as long as investors do their homework. "Rigorous credit evaluation is the best way to avoid these risks," said Reliance Mutual Fund's Tripathi. "Some of the residual risks and exit options can be managed by adequate covenanting of various financial and operating parameters."
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